What is the accounting rate of return on the initial increase in required investment?

What is the Accounting Rate of Return?

Accounting Rate of Return refers to the rate of return which is expected to be earned on the investment with respect to investments’ initial cost and is calculated by dividing the Average annual profit (total profit over the investment period divided by number of years) by the average annual profit where average annual profit is calculated by dividing the sum of book value at the beginning and book value at the end by the 2.

Accounting Rate of Return Formula & Calculation (Step by Step)

Accounting Rate of Return (ARR) = Average Annual Profit /Initial Investment

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Source: Accounting Rate of Return (wallstreetmojo.com)

The ARR formula can be understood in the following steps:

1. First, figure out the cost of a project that is the initial investment required for the project.
2. Now find out the annual revenue expected from the project, and if it is comparing from the existing option, then find out the incremental revenue for the same.
3. There shall be annual expenses or incremental expenses compared with the existing option. All should be listed.
4. Now, for each year, deduct the total revenue less total expenses for that year.
5. Divide your annual profit arrived in step 4 by the number of years the project is expected to stay or the life of the project.
6. Finally, divide the figure arrived in step 5 by the initial investment, and resultant would be an annual accounting rate of return for that project.

Examples

Example #1

Kings & Queens started a new project where they expect incremental annual revenue of 50,000 for the next ten years, and the estimated incremental cost for earning that revenue is 20,000. The initial investment required to be made for this new project is 200,000. Based on this information, you are required to calculate the accounting rate of return.

Solution

Here we are given annual revenue, which is 50,000 and expenses as 20,000. Hence the net profit will be 30,000 for the next ten years, and that shall be the average net profit for the project. The initial investment is 200,000, and therefore we can use the below formula to calculate the accounting rate of return:

• Average Revenue: 50000
• Average Expenses: 20000
• Average Profit: 30000
• Initial Investment: 200000

Therefore, the calculation is as follows,

• = 30,000/200,000

ARR will be –

• ARR = 15%

Example #2

AMC Company has been known for its well-known reputation of earning higher profits, but due to the recent recession, it has been hit, and the gains have started declining. On investigation, they found out that their machinery is malfunctioning.

They are now looking for new investments in some new techniques to replace its current malfunctioning one. The new machine will cost them around $5,200,000, and by investing in this, it would increase their annual revenue or annual sales by $900,000. The device would incur yearly maintenance of $200,000. Specialized staff would be required whose estimated wages would be $300,000 annually. The estimated life of the machine is of 15 years, and it shall have a $500,000 salvage valueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more.

Based on the below information, you are required to calculate the accounting rate of return (ARR) and advise whether the company should invest in this new technique or not?

Solution

We are given annual revenue, which is $900,000, but we need to work out yearly expenses.

• Average Revenue: 900000
• Annual Maintenance: 200000
• Specialized Staff: 300000
• Initial Investment: 5200000

First, we need to calculate the depreciation expensesThe Depreciation Expense Formula computes how much of the asset's value can be deducted as an expense on the income statement. Formula for Straight-line depreciation method= Cost of an asset - Residual value/useful life of an asset.read more, which can be calculated as per below:

• = 5,200,000 – 500,000/15
• Depreciation = 313,333

Average Expenses

• = 200000+300000+313333
• Average Expenses = 813333

Average Annual Profit

• =900000-813333
• Average Annual Profit = 86667

Therefore, the calculation of the accounting rate of return is as follows,

• =  86,667 /5,200,000

ARR will be –

Since the return on dollar investment is positive, the firm may consider investing in the same.

Example #3

J-phone is set to launch a new office in a foreign country and will now be assembling the products and sell in that country since they believe that the government has a good demand for its product J-phone.

The initial investment required for this project is 20,00,000. Below is the estimated cost of the project, along with revenue and annual expenses.

Based on the below information, you are required to calculate the accounting rate of return, assuming a 20% tax rate.

Solution

Here we are not given annual revenue directly either directly yearly expenses and hence we shall calculate them per the below table.

Average Profit

=400,000-250,000

• Average Profit = 75,000

The initial investment is 20,00,000, and therefore we can use the below formula to calculate the accounting rate of return:

Therefore, the calculation is as follows,

• = 75,000 /20,00,000

ARR will be –

ARR Calculator

You can use this calculator

Relevance and Uses

Accounting Rate of Return formula is used in capital budgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds.read more projects and can be used to filter out when there are multiple projects, and only one or a few can be selected. This can be used as a general comparison, and in no way it should be construed as a final decision-making process, as there are different methods of capital budgeting, which helps the management to select the projects those are NPV, profitability IndexThe profitability index shows the relationship between the company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability. One plus dividing the present value of cash flows by initial investment is estimated. It is also known as the profit investment ratio as it analyses the project's profit.read more, etc.

Further management uses a guideline such as if the accounting rate of return is more significant than their required quality, then the project might be accepted else not.

Recommended Articles

This has been a guide to the Accounting Rate of Return and its definition. Here we learn how to calculate ARR using its formula and practical examples, and a downloadable excel template. You can know more about financing from the following articles –

• Sampling Error Formula
• Calculate Rate of Return on Investment
• Formula of Profitability Index
• Rate of ReturnThe real rate of return is the actual annual rate of return after taking into consideration the factors that affect the rate like inflation. It is calculated by one plus nominal rate divided by one plus inflation rate minus one. The inflation rate can be taken from consumer price index or GDP deflator.read more